This is how to tell whether China is really heading in the right direction

A
guard in front of the Great Hall of the People at sunrise in
2004.Reuters

Economist Michael Pettis, a superstar of China analysis, wrote a
must-read (but massive) blog post on the state of the Chinese
economy and whether planned reforms are likely to work.

There are a lot of uncertainties in terms of timing and policy
implementation, he said.

What Pettis considers a certainty is how the world will know
China's serious problems with debt and overcapacity are being
dealt with.

From his blog post:

It is only when credit growth begins to decelerate much more
rapidly than nominal GDP growth that we can begin to talk
hopefully about China's moving in the right direction, and it is
only when credit growth falls permanently below the growth rate
of the economy's debt-servicing capacity that China will have
adjusted.

China's economy is transitioning from a system based on
investment to one based on consumer consumption. During those
investment years, China's massive state-owned enterprises racked
up a ton of debt, and now it's making them unproductive.

When companies are paying off debt, they're not reinvesting or
expanding. They're not hiring people. They may have to lay off
workers. Worse, down the line, they may not be able to pay their
creditors.

You see how this is a problem.

And it's only getting worse

China is still working on figuring out how to restructure this
debt. In the meantime, the debt keeps mounting in the form of
credit extended to companies to keep them running.

The thing is, the longer this goes on, the less impact credit
actually has.

According to Bloomberg, every dollar of new credit added to
China's economy adds 27 cents to gross domestic product. Back in
2011 it generated 59 cents.

This is hedge fund manager Jim Chanos, the famed
China bear and short seller, calls "China's treadmill to hell."

In short, when China's corporate sector doesn't have to live on
credit anymore, we'll know reforms are doing their work and the
economy is finally running somewhere.

Of course it's how the government gets there that's so painful
and complicated.